-Shane Battier, in a post game interview last Thursday after hitting six 3-pointers to help the Heat win game 7 over the Spurs to take their second straight NBA title. Battier used that tongue-in-cheek quote to respond to a question from Doris Burke on how he was able to turn around his performance. He was benched in numerous games during the post season in large part because of his poor performance. That changed in game 7.

I felt like Shane Battier on Thursday when I saw EBIX’s stock drop over 40% in one day. It then dropped another 25% Friday morning as panic and forced selling took over after the announcement that a Goldman Sachs subsidiary was backing out of the deal to buy EBIX at $20.50 per share. I felt lucky because I was interested in investing in Ebix as a merger opportunity that I felt actually had potential for upside. I wrote this article on a few similarities between Dell and EBIX, but fortunately never got around to buying shares in EBIX as I was more interested in other ideas. So obviously I was lucky there. However, I most likely would still be holding shares and maybe adding if I owned EBIX. And I chose to initiate a small position Friday around $8.75 per share.

(Note: it’s a small position. Why? Because I generally run a diversified basket approach to investing in these types of stocks. I choose to mitigate risk through diversification at the portfolio level. This allows me to own numerous undervalued securities with problems but also with asymmetric risk-return profiles. What this means is that on balance, I think there will be more winners than losers and the amount of the winners will exceed the amount of the losers. It’s similar to the insurance underwriting business. Having said that, Ebix might be one of the losers. I have no idea. But I do believe the stock is dramatically mispriced in one direction or another).

So I think that at $20, the stock is (was) cheap. At $10, it’s completely mispriced.

As Jamie Mai (of Cornwall Capital and Big Short fame) has pointed out with various investments, sometimes stocks are either worth $0 or worth $20, but not $10. I think that’s the case here. The market doesn’t know how to price Ebix at the moment, so it sits on the fence until uncertainty is resolved. I think this is an opportunity for value investors, as long as they understand the risk.

Beware the Risk

The risks are very real, and due to brevity, I’ll simply link to the shorts’ ideas which I found very detailed and thorough. As far as I know, they may be right. But I have a few reasons to think they may be wrong as well. But in a situation like this, it is very helpful to study the risks.

The Ebix debacle started with this article on seeking alpha from over two years ago. There were a few other articles on Seeking Alpha that shed light on the potential problems at EBIX. The thesis basically revolves around the accounting practices at the firm, which some feel are hiding certain liabilities and also evading certain corporate income taxes. Read all the posts for details. Then earlier this year, another short poster wrote this research piece on why he thinks EBIX is a fraud. The latter poster has also written follow up pieces. It also helps reading through the comments in each of the pieces. You have to sift through a lot of useless comments, but you’ll find a few that are from very knowledgeable sources. For a counterpoint to the above theses, check out this post.

EBIX—Cheap and Good?

I have been following EBIX since coming across it a number of months ago in Greenblatt’s Magic Formula screen. I won’t go into too much detail here, but just wanted to describe some of my own thoughts on EBIX.

It’s a company that sells software and e-commerce solutions to insurance companies. They provide back office solutions for these companies with the goal of improving the efficiency of their customer’s operations. They also provide services to banks, financial advisors, and other corporate clients. They have a widely diversified customer base with (according to EBIX) a recurring revenue base of around 80%. This means many of the customers continue to buy the products and services on a repeat basis, providing steady and stable cash flow for Ebix.

This recurring revenue along with the low fixed costs needed to operate the business (leading to very high free cash flow, high gross margins, and above average returns on capital) are what I like most about the EBIX business model. On the surface, it appears to be an outstanding company. Check out the 10-year financials... high margins, high returns, and growing sales and cash flow:

So the company appears to be generating really good results. The kind of results that typically would demand premium valuations. However, after the nearly 60% price reduction, you can buy this company at roughly these single digit valuations:

EV/EBIT: 5

P/E: 5

P/FCF: 5

EV/EBITDA: 4

At my Friday purchase price, you could buy a company that has averaged 27% revenue growth and 44% EBITDA growth over the last 10 years for 3.8 times EBITDA and more than a 20% free cash flow yield!

I got lucky again because shortly after I completed my purchase, the company announced that it approved a $100 million buyback. At the Friday valuation, this represented close to 30% of the outstanding shares. The announcement felt like a reaction to the negative headlines more than a thoughtful business decision, but nevertheless, I think a buyback makes tremendous sense at these valuations.

Think about this: the company generated around $70 million of free cash flow in the last 12 months. At that rate, it could buy back the entire value of the company in about 5 years.

One of the short theses is that the company will face serious tax consequences that may lead to significantly higher tax rates and/or significant tax penalties. Let’s assume EBIX has to pay the $100 million penalty (I have no idea where the short poster got this number), it could pay back the penalty in 18 months using its own free cash flow. Let’s further assume that EBIX is levied with a new tax rate that causes taxes to go up and reduce free cash flow by 30%. In that case, EBIX might make $50 million in free cash flow. So it will take maybe 24 months to pay off this hypothetical tax penalty.

Of course, these are wild guesses from both the short poster and myself. Penalties could go much higher, but they might also not be nearly as bad. The market is assuming they will be very bad. But my experience is that in many cases like this, the downside is already priced in. The business model has been very successful, and the company is producing real cash (as opposed to juiced earnings but negative free cash as was the case with many frauds of the past like Enron, Worldcom, etc…).

CEO Owns Large Position

Another reason I don’t think that EBIX is a complete fraud and going to $0 is that the company’s CEO Robin Raina owns about 10% of the outstanding stock. Raina is an entrepreneur who transformed EBIX’s business a decade ago. He has a large portion of his net worth tied to EBIX stock. With around $40 million personally riding on the fortune of the company, I doubt that we will see EBIX become worthless. Again, this is opposite of many frauds of the past where we saw many insiders selling in droves as their stock approached new highs on the back of record earnings (but large negative free cash flows).

To Sum it Up

Ebix is an interesting situation. I decided it warranted a small position. You might wonder why I decided to write 1,300 words on a stock that represents such a small portion of my portfolio. One is that most stocks I own are hated for one reason or another and represent individually, very small portions of the portfolio, as I mentioned above. This style of investing is one of three main strategies I use in my portfolio.

The other reason I commented on this stock is simply because it’s a widely scrutinized situation that I find interesting. I think the upside is significant for the stock, but the risks are real so you mitigate those by using a basket approach with other similarly undervalued stocks.

I am glad that I avoided the huge downdraft, and like Shane Battier said, “sometimes it’s better to be timely than good.” I also think that we might see a reversion to the mean in this stock, similar to Battier’s reversion to the mean performance in game 7. It will be interesting to watch either way. Hopefully watching the EBIX outcome will be as much fun as the Spurs-Heat were in the NBA finals this year.

Full Disclosure: I own shares of DELL and EBIX.

Please remember that this post does not represent a recommendation to purchase shares of any of the securities mentioned. It is also not a comprehensive report on any of the stocks mentioned. Please do your own due diligence to reach your own conclusions. I have no idea of your personal financial situation. Investing has certain risks that may not be suitable for you.

About the author:

John Huber

I am the Portfolio Manager at Saber Capital Management, LLC. Saber manages an investment partnership as well as separately managed accounts for clients interested in a focused value investing strategy. My investment style has been most influenced by Ben Graham, Walter Schloss, Warren Buffett, and Joel Greenblatt. I am also the author of www.BaseHitInvesting.com, a value investing blog.

Comments

I also come cross this deeply undervalued stock. The U.S. Attorney for the Northern District of Georgia began investigating allegations of misconduct at Ebix. It is a letigation and I think the risk can't be quantified at this moment unless you are an expert of law.

Beware....like him or hate him, using the word "crook" to describe someone can often be held up as libel or slander in a court of law.....even if you call an attorney a crook (go figure). Just a friendly word of caution.

I like old trucks and bought a 1954 chevy that was running when it was parked. I have since learned that most old trucks for sale that are not running now were running when they were parked. Makes perfect sense. Nary a seller will say 'it was parked when i parked it'. i realize that 'it was running when i parked it' is totally meaningless when buying old trucks that aren't runnning now. It reminds me of long articles where the author didn't buy or adds a caveat about a small position.

here's my take: too much smoke here with busted deal and gotham alleging accounting fraud. I spent two seconds to review the company's audit firm since no public company post enron facing accounting fraud headwinds would settle for anything less than top big four firm. Turns out they use a firm I have never heard of before and I've been in the accounting business for 20 years. Maybe their existing audit firm is a nice firm but maybe you increase audit fees 3x by hiring the best and brightest and avoid a 50% haircut in your market cap especially in this industry with complex revenue recognition rules.

I'm taking a pass but good luck with the small position. I look forward to your next article when you are pounding the table about an idea that is meaningful to you.

Kirrct, I don't pound tables. I simply am trying to be open and transparent about my opinion and since it is a stock in the news, thought I'd comment on it. The article's purpose is not to try and convince you or any other readers to buy the stock. The purpose for most of my writing is to simply write down my thesis which helps me in my own investing. The reason I mention a small position is so readers can gauge my levels of conviction. If you were hoping for a higher level of conviction, I'm sorry to disappoint. My conviction, or lack thereof is directly related to why my position is small. It's just the tactic I use to mitigate the risks, which are prevalent.

I'm simply underwriting the risks that you and others have mentioned with this (and most of my other) positions.

"The business model has been very successful, and the company is producing real cash (as opposed to juiced earnings but negative free cash as was the case with many frauds of the past like Enron, Worldcom, etc…)."

John, I was reading the 10K of EBIX and I would remain skeptical with regards to the net cash provided by operating activities and their accounting in general. Here are a few red flags or mild warnings I came across just by browsing the 10K.

1. Reported revenue and accounts receivable have increased every year but the allowance for doubtful account has decreased. (from $1,719 in 2011 to only $1,157 in 2012).

2. I may be wrong but my calculation shows an increase in AR of $6,165 from 2011 to 2012 ($37,298 -$31,133) but only $2,023 is reflected in the statement of cash flow. Either they are trying to hide something or their calculation is incorrect, but both cases could indicate serious manipulation or defect in financial reporting.

3. The short sellers have noted this but organic growth is dubious and whenever you have a company grows out of acquisition, you should try to get a real sense of the growth by stripping out the impact of the acquired companies.

4. This is disclosed by the company: "Approximately $7.0 million and $8.3 million of deferred

revenue were included in accounts receivable at December 31, 2012 and 2011, respectively." I am not going to say this violates GAAP but this is very aggressive accounting. Good businesses don't recognize deferred revenue out of accounts receivable. Deferred revenue is recorded when you get paid in advance, not when you bill customer in advance.

The above are just a few examples. There are many other questionable accounting issues in the 10K. I understand you are underwriting the risks and this is a small investment. Just thought you may want to go through EBIX's 10K more thoroughly should you decide to add your position or hold it for a longer time horizon.

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